Supervisory Guidance for Managing

Settlement Risk in

Foreign Exchange Transactions

Basel Committee on Banking Supervision

BaselSeptember 2000

Risk Management Groupof the Basel Committee on Banking Supervision

Chairman:Mr Roger Cole – Federal Reserve Board, Washington, D.C.

Banque Nationale de Belgique, Brussels Ms Ann-Sophie Dupont

Commission Bancaire et Financière, Brussels Mr Jos Meuleman

Office of the Superintendent of Financial Institutions, Ottawa Ms Aina Liepins

Commission Bancaire, Paris Mr Olivier Prato

Deutsche Bundesbank, Frankfurt am Main Ms Magdalene Heid

Bundesaufsichtsamt für das Kreditwesen, Berlin Mr Uwe Neumann

Banca d’Italia, Rome Mr Sebastiano Laviola

Bank of Japan, Tokyo Mr Toshihiko Mori

Financial Services Agency, Tokyo Mr Takushi FujimotoMr Satoshi Morinaga

Commission de Surveillance du Secteur Financier,Luxembourg

Mr Davy Reinard

De Nederlandsche Bank, Amsterdam Mr Klaas Knot

Finansinspektionen, Stockholm Mr Jan Hedquist

Sveriges Riksbank, Stockholm Ms Camilla Ferenius

Eidgenössiche Bankenkommission, Bern Mr Martin Sprenger

Financial Services Authority, London Mr Jeremy QuickMr Michael Stephenson

Bank of England, London Ms Alison Emblow

Federal Deposit Insurance Corporation, Washington, D.C. Mr Mark Schmidt

Federal Reserve Bank of New York Mr Stefan Walter

Federal Reserve Board, Washington, D.C. Mr David Elkes

Office of the Comptroller of the Currency, Washington, D.C. Mr Kevin Bailey

European Central Bank, Frankfurt am Main Mr Panagiotis Strouzas

European Commission, Brussels Mr Michel Martino

Secretariat of the Basel Committee on Banking Supervision,Bank for International Settlements

Mr Ralph NashMr Guillermo RodriguezGarcia

Table of Contents

I INTRODUCTION...................................................................................................................................... 1

II THE NATURE OF FX SETTLEMENT RISK........................................................................................ 2

III SENIOR MANAGEMENT RESPONSIBILITIES ................................................................................. 3

IV DURATION OF FX SETTLEMENT EXPOSURE ................................................................................ 3

V MEASUREMENT OF FX SETTLEMENT EXPOSURES.................................................................... 5

VI SETTING AND USING LIMITS ............................................................................................................. 6

VII PROCEDURES FOR MANAGING FAILS AND OTHER PROBLEMS ............................................ 7

VIII CONTINGENCY PLANNING ................................................................................................................. 8

IX IMPROVING THE MANAGEMENT OF FX SETTLEMENT EXPOSURES ................................... 8

X USE OF BILATERAL NETTING............................................................................................................ 9

XI ALTERNATIVE ARRANGEMENTS FOR FX SETTLEMENT RISK REDUCTION ................... 10

XII INTERNAL AUDIT................................................................................................................................. 11

XIII A BANK'S RESPONSIBILITIES TO ITS COUNTERPARTIES....................................................... 11

XIV THE ROLE OF SUPERVISORS............................................................................................................ 12

APPENDIX 1: KEY FX SETTLEMENT RISK CONCEPTS ........................................................................ 14

APPENDIX 2: POSSIBLE QUESTIONS FOR ON-SITE REVIEWS ........................................................... 16

APPENDIX 3: ANNOTATED BIBLIOGRAPHY ........................................................................................... 18

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Supervisory Guidance for Managing Settlement Riskin Foreign Exchange Transactions

I Introduction

1. Foreign exchange (FX) settlement risk is the risk of loss when a bank in a foreignexchange transaction pays the currency it sold but does not receive the currency it bought. FXsettlement failures can arise from counterparty default, operational problems, market liquidityconstraints and other factors. Settlement risk exists for any traded product but the size of theforeign exchange market makes FX transactions the greatest source of settlement risk formany market participants, involving daily exposures of tens of billions of dollars for thelargest banks. Most significantly, for banks of any size, the amount at risk to even a singlecounterparty could in some cases exceed their capital.

2. FX settlement risk is a form of counterparty risk involving both credit risk andliquidity risk. As with other forms of risk, banks need to ensure that they have a clearunderstanding of how FX settlement risk arises. On the basis of this understanding, policiesfor managing the risk should be developed at the highest levels within the bank andimplemented through a formal and independent process with adequate senior managementoversight. As part of this process, a bank has to have measurement systems that provideappropriate and realistic estimates of FX settlement exposures on a timely basis. Thedevelopment of counterparty settlement limits and the monitoring of the exposures againstthese limits is a critical control function. The bank also needs to have procedures for reactingin a prompt and balanced manner to failed transactions or other settlement problems.

3. The purpose of this guidance is to provide banking supervisors with informationabout FX settlement risk and its management that they should take into account whenassessing a bank's policies and procedures. Establishing and implementing proper riskmanagement policies can be a major task for a bank and it is likely that not all banks will havecompleted this task yet. However, understanding and recognition of FX settlement risk hasincreased significantly in recent years, not least because of the work of the Committee onPayment and Settlement Systems (CPSS) of the Bank for International Settlements, inparticular their reports, Settlement Risk in Foreign Exchange Transactions (March 1996) andReducing Foreign Exchange Settlement Risk: A Progress Report (July 1998).1 All banksshould therefore be expected to have a good understanding of FX settlement risk and to haveformulated clear and firm plans for how to manage it. Even if those plans have not yet beenfully implemented, the process of doing so should be well underway.

4. This guidance was drawn up in close consultation with the CPSS. It has alsobenefited from comments received on the consultative draft issued in July 1999.

1 These documents as well as other useful material related to foreign exchange settlement risk and other types of settlementrisk are listed in the annotated bibliography provided in Appendix 3.

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II The nature of FX settlement risk

5. FX settlement risk clearly has a credit risk dimension. If (as is usually the case undercurrent market practices) a bank cannot make the payment of the currency it sold conditionalupon its final receipt of the currency it bought, it faces the possibility of losing the fullprincipal value of the transaction. It is true that, in practice, the majority of FX settlementfailures arise for operational or other routine reasons, in which case the bank does in duecourse receive the currency it has purchased. Nevertheless, the risk exists that thecounterparty will default outright and the principal will be lost. Banks therefore should treatFX exposures as being equivalent to other credit exposures of the same size andduration.2 Moreover, as discussed below, they need to take into account the fact that standardsettlement practices mean that this exposure is not necessarily an intraday phenomenon:exposures frequently last overnight and can last for several days.

6. FX settlement risk also has an important liquidity risk dimension. Even temporarydelays in settlement can expose a receiving bank to liquidity pressures if unsettled funds areneeded to meet obligations to other parties. Such liquidity exposure can be severe if theunsettled amounts are large and alternative sources of funds must be raised at short notice inturbulent or unreceptive markets.

7. FX settlement risk has other dimensions as well. For example, there is legal risk – i.e.the risk that legal difficulties may exacerbate the credit or liquidity risk facing the bank as aresult of a settlement failure. In the case of foreign exchange deals, legal risk can becomplicated by the fact that settlement normally takes place in more than one jurisdiction.There is also a particularly important systemic risk dimension. As already noted, the size ofsome banks' FX exposures relative to their capital creates the real danger that a failure of onecounterparty of a bank could lead to that bank's insolvency.

8. The scale and nature of FX settlement risk depends, in part, on the method ofsettlement. At the moment, the majority of deals are settled gross – i.e. each deal is settledindividually through payments made via correspondent banks (or branches of the counterpartybanks) in the currencies concerned. This guidance concentrates on the risks that arise fromsettling gross because a thorough understanding of how these risks should be managed is apre-requisite for understanding other settlement methods.3 At the moment, the principalalternative settlement method is to use bilateral netting. In the future it is likely that furthersettlement methods will also be available, including the FX settlement system beingdeveloped by CLS Bank. Later sections of the guidance look at some of the risk managementimplications of these alternative settlement methods.

2 It is worth noting that FX settlement risk is not intended to attract a minimum capital requirement under the new capitaladequacy framework. Supervisors would be free to impose a charge for this, or other risks, under the supervisory reviewprocess and banks may wish to consider this exposure in their internal capital allocations. The proposed capital charge foroperational risk is intended to take into account operational risk exposure arising from FX settlement.

3 Note that the term “gross” is used here to indicate a process in which each FX deal is settled individually by traditionalcorrespondent bank methods. It does not mean that any payment system used by the correspondent banks as part of thisprocess is necessarily a gross settlement system.

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III Senior management responsibilities

9. A bank’s procedures for managing its FX settlement risks should be commensuratewith the range and scope of its activities. However, in all cases and regardless of thesettlement method used, FX settlement risk management should begin at the highest levels ofthe organisation, with a policy on FX settlement risk from the bank's board of directors. Thispolicy should be an integral and consistent part of the bank's overall policy towardscounterparty risk. It should be regularly reviewed and, where necessary, modified to takeaccount of new circumstances such as changes in the scale or nature of the bank's FXoperations or in the method of settlement used.

10. Senior management should exercise appropriate oversight of settlement exposures.Although specific organisational approaches may vary across banks, FX settlement riskmanagement should be integrated into the overall risk management process. Managing FXsettlement risk involves many different functional areas of a bank, including trading, credit,operations, legal, risk assessment, branch management, and correspondent relations. In larger,more complex banks, counterparty exposures may also run across departments, branches andlegal entities, and may encompass multiple product lines, such as lending and FX trading.Banks should have clear procedures for measuring and managing exposures that provide forthe efficient aggregation of all components of credit risk toward a counterparty. This is aprerequisite for the proper functioning of the overall risk management process. Only seniormanagement can effect the co-ordination necessary to achieve this. Management informationsystems should also support the integration of the necessary information.

11. Accordingly, senior management should ensure that they fully understand the FXsettlement risks incurred by the bank and should clearly define lines of authority andresponsibility for managing these risks. Adequate training should be provided to all staffresponsible for the various aspects of FX settlement risk. Senior management and staff shouldunderstand that counterparty default is not so rare as to obviate the need for strong riskmanagement. While defaults by major banks are uncommon, the extremely large FX tradingexposures, including those that can last for several days (as discussed below), merit moreprudent risk management than is currently found in many banks.

IV Duration of FX settlement exposure

12. FX-related payments generally are made in two primary steps: the sending ofpayment orders and the actual transmission of funds. It is important to distinguish betweenthese two steps: the first is an instruction to make a payment, while the second involves anexchange of credits and debits across correspondent accounts and the accounts of the centralbank of the currency involved.4 The first step is normally effected one or two days beforesettlement date (although there are some variations according to currency and institution)while the second stage takes place on the settlement date itself.

4 Alternatively, final payment may be made by book-entry transfer if the two trading counterparties have the samecorrespondent.

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13. A bank’s FX settlement exposure runs from the time that its payment order for thecurrency sold can no longer be recalled or cancelled with certainty – the unilateral paymentcancellation deadline – and lasts until the time that the currency purchased is received withfinality. Note that this is the duration of the exposure. It says nothing about the probability offailure and thus the degree of risk faced by the bank during the period. Depending on theinformation available to the bank about the creditworthiness of the counterparty or the statusof the funds it is due to receive, its assessment of the probability of failure and thus the degreeof risk may change during the time the exposure is outstanding. This is, of course, normal forany credit exposure.

14. To measure and manage their FX exposures, banks need to be certain when theirunilateral cancellation deadline is for each currency. It might be expected that banks couldcancel payment orders up until the moment before the funds are finally paid to a counterparty.However, correspondent and payment system practices, as well as operational and even legalarrangements, typically result in payment orders becoming effectively irrevocablesignificantly before the time of payment.

15. A key factor in determining the unilateral cancellation deadline is the latest time acorrespondent can guarantee to satisfy a cancellation request. The documentation covering acorrespondent’s service agreement should identify this cancellation cut-off time. Thisdocumentation is particularly important because, in the event the bank wishes to cancel itspayment instruction, the bank and its correspondent are likely to rely upon the terms andconditions stipulated in the agreement. However, in some cases banks may have no writtenagreement at all with their correspondent or the agreement may not specify a guaranteed cut-off time. Where this is the case, banks should negotiate with their correspondent; this mayrequire a change in nature of the relationship between the bank and its correspondent,recognising that the two need to work together to manage risks effectively.

16. In assessing their unilateral payment cancellation deadlines, banks should be able todemonstrate that they can in practice identify and hold particular payments up to the cut-offtimes guaranteed by their correspondents, as internal processes and other practical factors maylimit their ability to do so. In many cases, the effective unilateral payment cancellationdeadline will be earlier than the guaranteed cut-off time - indeed, in some cases the unilateralpayment cancellation deadline may even be earlier than the time the payment order isnormally sent to the correspondent. These earlier times could occur, for example, if paymentorders were normally processed automatically but cancelling an order required time-consuming manual intervention. Moreover, due to automated processing, a bank may not beable to stop one payment instruction without ceasing or disrupting all outgoing paymentinstructions. Because a bank’s management is unlikely to want to suspend payments to theirsolvent counterparties (and face subsequent demands for compensation), an all or nothingcapability to cease outgoing payment instructions should not be accepted as the ability toeffect unilateral cancellation of payments to a single counterparty. Finally, some deadlinesquoted by correspondents may fall outside normal working hours, in which case the bank mayneed additional time to meet the deadline. Because of these and other factors, banks shouldconsider testing their procedures with their branches and correspondents in simulations of

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emergencies in order to help determine the effective unilateral payment cancellationdeadline.5

V Measurement of FX settlement exposures

17. The actual duration of FX settlement exposure - namely, the interval from theunilateral payment cancellation deadline for the sold currency until final receipt of the boughtcurrency - is generally referred to as the period of irrevocability. When trades are settledgross, the full face value of the trade is at risk during this period, which can last overnight andup to two or three full days. If weekends and holidays are included, the period ofirrevocability – and consequent exposure – can exist for several more days.

18. A bank’s minimum FX settlement exposure at a specified time includes the value ofall outstanding trades where payment is irrevocable; it also includes any known failed receiptssince, by definition, the fact the trade has failed to settle means the funds have not yet beenreceived. Because the irrevocable period can last several days, this minimum measure ofexposure may be equal to several days’ worth of trades. In this situation, a bank might finditself in the position of paying a counterparty on one day when it had not been paid on theprevious day(s).

19. A bank's measurement of its exposure also needs to take account of the process ofreconciling incoming payments with expected receipts. The actual exposure of the bank endswhen the bought currency is received with finality. However, in the interval between expectedreceipt and reconciliation, referred to as the period of uncertainty, the bank does not knowwhether it has received payments from particular counterparties and will therefore be acting inignorance of any failed receipts. When measuring its exposure, a prudent bank will thereforeassume that during this uncertain period the funds have not been received. Consequently, themaximum settlement exposure at a specified time equals the minimum exposure plus the valueof all uncertain receipts at that time.

20. Note that the period of uncertainty only ends when a bank has positively confirmedthat the funds have been received. Positive confirmation means that a bank not only hasreceived information from its correspondents about the payments credited to its nostroaccounts but also has processed that information to determine which trades have successfullysettled and which, if any, have failed.6 It is not enough for banks to measure their exposure onthe basis that, provided they have no news of the counterparty having defaulted, it is safe forthem to assume that the funds either have been or will be received. Until the receipt of thefunds has been positively confirmed, there always remains the possibility that in fact theyhave not been received and that the counterparty will default.

5 For example, the bank could attempt to cancel payment instructions (concerning payments set up specially for testpurposes) which it had sent to its correspondent.

6 It is not unusual for the reconciliation process to take place some considerable time after information is received from acorrespondent. (For example, the bank may receive the information late on the settlement day but not process theinformation until the next working day.) Banks need also to ensure that payments shown as being credited to their nostroaccounts have been credited with finality, rather than as provisional funds (e.g. pending final settlement within a paymentsystem).

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21. Measuring FX settlement exposures requires a bank to identify explicitly both theunilateral payment cancellation deadlines and the reconciliation process times involved ineach type of currency transaction. An exact measure of FX exposures has to recognise that theduration of exposures varies by currency pair and that a bank's exposures are likely to changeduring the day. Exact measurement has the advantage of avoiding overestimation as well asunderestimation.7 Nevertheless, the process involved is relatively complex and so, foroperational and system reasons, most banks do not measure their exposures exactly. Insteadvarious estimation methods are used. In particular, many banks define and measure their dailysettlement exposures as the total receipts coming due on settlement day.

22. Estimation techniques can be appropriate – but only if they do not significantlyunderestimate exposures. However, in practice simple estimation techniques frequently dounderstate settlement exposures. One problem is that even where exposures last for less than24 hours, this period may overlap more than one calendar day. For example, the period maystart during the evening of the day before settlement and run until late afternoon of thesettlement day; in this case, estimating the daily exposure as the receipts due on the settlementday could underestimate the actual exposure late in the day. Moreover, as noted in paragraph18 above, exposures often last more than one day. Simple approximation methods forimproving this technique, such as using multiples of daily trades, may not sufficiently accountfor variations in the value of daily trades.

23. Where estimation techniques are used, management should therefore be able todemonstrate clearly how settlement exposure is measured, and that, even in abnormalcircumstances, the estimation techniques will not significantly underestimate the exposure.Even estimation techniques require a bank to have a thorough understanding of both theunilateral payment cancellation deadlines and the reconciliation process times involved ineach type of currency transaction.

24. Finally, it is critical that banks' measurements of FX settlement exposures andassociated risks are integrated into their overall risk measurement and management processes.In particular, banks have increasingly adopted consolidated risk measurement and capitalallocation methodologies, a trend that supervisors have strongly supported. Where suchmethodologies are used, appropriate measures of FX settlement risk should be included sothat internal capital allocations properly reflect the risks associated with this activity.

VI Setting and using limits

25. Banks should ensure that settlement exposures to counterparties are subject toprudent limits. FX settlement exposures should be subject to an adequate credit controlprocess, including credit evaluation and review and determination of the maximum exposurethe bank is willing to take with a particular counterparty. Through this process, an FXsettlement limit should be established for each counterparty. The FX settlement exposurelimit should be subject to the same procedures used to devise limits on other exposures of

7 Overestimation has disadvantages: it may lead to inefficient use of counterparty credit limits or to excessive expansion ofcredit limits to offset the overestimate. However, underestimation is clearly a more serious problem.

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similar duration and size to the same counterparty. For example, in cases where the FXsettlement exposure to a counterparty lasts overnight, the limit might be assessed in relation tothe bank’s willingness to lend funds to its counterparty on an overnight basis. Limits shouldbe based on the level of credit risk that is prudent and should not be set at an arbitrary, highlevel just to facilitate trading with a counterparty.

26. The limits applied by a bank to its FX settlement exposures should be binding – i.e.FX deals should not be struck that would cause counterparty limits to be exceeded. Anyplanned excesses should be subject to approval by the appropriate credit managementpersonnel in advance of the excess occurring. However, unplanned excesses may sometimesoccur. This may be because, when the deal is struck, the headroom apparently available undera limit has not yet been reduced to reflect other deals recently struck. Or it may be because,when the time comes for the deal to be settled, unexpected events (such as the failure of othertransactions to settle) cause exposures to be higher than planned. Banks should take steps tominimise these possibilities. Exposure measures should be updated promptly when new dealsare struck or when events (such as fails) mean that the exposures from existing trades lastlonger than expected. Effective monitoring is crucial to the management of FX settlementrisk, and banks with large exposures should have systems that enable them to monitordevelopments in real-time (or close to real-time) in order to ensure that these exposures do notexceed settlement limits. A bank may want to put additional emphasis on those exposures thatare particularly large or are with less-creditworthy counterparties or where there has been aseries of fails that may indicate an underlying credit-worthiness problem. However, if, despitethese precautions, unauthorised excesses do still occur, a review by the credit managementpersonnel should take place shortly thereafter so that any necessary corrective action can betaken.

VII Procedures for managing fails and other problems

27. Operational errors are the most common source of fails. While such mistakes may beinadvertent and corrected within a reasonable time, they may in some cases be indicative ofmore fundamental problems, including credit problems, and so banks should have proceduresfor quickly identifying fails and taking appropriate action. Such action should normallyinvolve informing the credit department, so that a judgement can be made about theseriousness of the problem. Because a fail represents continued exposure to the counterpartyfor the full principal value of the trade, banks should include fails in their measures of currentand expected exposure (as noted in paragraph 18 above). Banks may also need to take steps toobtain the funds due and to try to avoid recurrences.

28. When reacting to a fail or to another potential problem with the settlement of an FXdeal, banks need to strike a balanced approach. If there appears to be an underlying credit-worthiness problem, the bank may decide that it is prudent to reduce its limit for thatcounterparty. In more extreme cases, it may decide that, to protect itself from settlement risk,it needs to suspend issuing payment instructions for outstanding deals with that counterpartyor to cancel existing payment instructions (if possible). However, failure to pay could haveserious consequences; it could constitute a breach of contract by the bank and may causeliquidity problems for the counterparty. Such action should thus only be taken when, after acareful but prompt review of the circumstances, the bank's senior management judges that thesituation warrants it.

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VIII Contingency planning

29. Contingency planning and stress testing should be an integral part of the FXsettlement risk management process. Contingency plans should be established to include abroad spectrum of stress events, ranging from internal operational difficulties to individualcounterparty failures to broad market related events. Adequate contingency planning in theFX settlement risk area includes ensuring timely access to key information, such as paymentsmade, received or in process, and developing procedures for obtaining information andsupport from correspondent institutions. An institution should also have a contingency plan inplace to ensure continuity of its FX settlement operations if its main production site becomesunusable. This plan should be documented and supported by contracts with outside vendors,where such vendors provide services to the bank that are necessary either to the bank's normalFX settlement or to its contingency plans. Because in many cases the action taken will besimilar, contingency planning for FX settlement problems should be co-ordinated with theplanning for other problems (such as payment system or trading room failures). Contingencyplans should be tested periodically.

IX Improving the management of FX settlement exposures

30. Banks should actively manage their exposures. There are various steps banks cantake to reduce the duration or size of the settlement exposures relating to their FX deals. Theduration of exposures can be reduced by improving unilateral payment cancellation deadlinesby, for example, negotiating better cancellation cut-off times with correspondents andimproving internal processing. It is important to note that banks should not simply regularlydelay sending payment instructions to their correspondents as a way of improving theirperiods of irrevocability. Doing so without the correspondents’ consent could increase thecorrespondents’ operational risks and thus the risk that payment instructions are incorrectlyprocessed. Instead, banks should seek to negotiate explicit cancellation cut-off times withtheir correspondents. Banks need to have realistic expectations of what correspondent bankscan be expected to achieve, since later cancellation cut-off times have operational andliquidity consequences for the correspondent. Banks also need to be aware of the possibleliquidity risk in payment systems if late cut-off times cause FX-related payments to beconcentrated towards the end of the settlement day, adversely affecting system liquidity.

31. Better management of exposures can also be achieved by identifying receipts sooner,thereby bringing the maximum measure of exposure close to the minimum. To reduce theamount of time it takes to identify final or failed receipts, banks will need to considerimproving both arrangements for receipt of information from correspondents and the timethey conduct their own reconciliations.

32. Appropriately managed collateral arrangements and legally sound netting agreements(see below) are also important risk management tools that can reduce the amount of a bank’sexposure to a particular counterparty for a particular level of trading.

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X Use of bilateral netting

33. Banks can reduce the size of their counterparty exposures by entering into legallybinding agreements to net settlement payments bilaterally.8 Legally binding payment nettingarrangements permit banks to offset trades against each other so that only the net amount ineach currency is paid or received by each institution. Such payment netting arrangements arecontemplated in the industry standard bilateral master agreements covering FX transactions.

34. Depending on trading patterns, bilateral payment netting can significantly reduce thevalue of currencies settled. It also reduces the number of payments to one per currency eitherto or from each counterparty. Bilateral payment netting is most valuable when thecounterparties have a considerable two-way flow of business; as a consequence it may only beattractive to the most active banks. To take advantage of risk reducing opportunities, banksshould be encouraged to establish procedures for identifying payment netting opportunities.

35. Use of bilateral payment netting requires some modification to the method ofmeasuring settlement exposures explained earlier. When bilateral payment netting is used, allthe transactions with a particular counterparty due to settle on that day have to be consideredtogether: the bank will make a single payment to the counterparty in each of the currencieswhere it has a net debit position, and receive a single payment in each of the currencies whereit has a net credit position. The maximum value of the resulting settlement exposure is simplyequal to the sum of the amounts due to be received from the counterparty. However,measuring the actual duration of the exposure is more complicated because nettedtransactions result in a set of payments in a number of currencies, no two of which can simplybe paired to calculate the period of irrevocability. Rather, the exposure will build up to itsmaximum value as the cancellation deadline for each of the net debit currencies paid isreached, and will fall as each of the net credit currencies is received. Any method ofmeasurement – whether an exact measure or an approximation – needs to make appropriateallowance for this.

36. Moreover, to allow exposures to be measured on a net basis, the legal basis forpayment netting arrangements should be sound. In particular, banks should ensure that anetting arrangement is legally enforceable in all relevant jurisdictions.

37. Some banks use informal payment netting - i.e. where there is no formal nettingcontract between the counterparties. In this instance, the back offices of each counterpartyconfer by telephone before settlement and agree to settle only the net amount of the tradesfalling due. Since there may not be a sound legal basis underpinning such procedures, banksshould ensure that they fully understand and appropriately manage the legal, credit, andliquidity risks of this practice. In particular, counterparty exposures should be treated on agross basis for risk management purposes unless the bank has obtained clear legal advice thatthe informal payment netting is legally sound. Additionally, the practice and associated risksshould be described in the bank’s policy and procedures.

8 Netting of payment obligations should not be confused with ‘close-out netting’, which requires counterparties to settle ona net basis all contracted but not yet due obligations immediately upon the occurrence of a defined event, such as theappointment of a liquidator to one of the counterparties. Although close-out netting may be a useful part of a bank'soverall risk management, it is not discussed further here as it does not, by itself, reduce routine FX settlement exposures.

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38. While bilateral netting arrangements can significantly reduce FX settlement risk,they are usually not capable of removing credit risk entirely. In addition, significant liquidity,legal and operational risks may remain. For example, if, because of operational problems,transactions that had been scheduled to be settled through a netting arrangement hadunexpectedly to be settled gross, a bank might not have the liquidity to settle thosetransactions on a timely basis.

XI Alternative arrangements for FX settlement risk reduction

39. Additional options may soon be available to reduce FX settlement risk. For example,a major project currently underway is the creation of CLS Bank, a private sectormulticurrency facility for settling FX transactions that involves payment-versus-paymentfunctionality. The achievement of payment-versus-payment in the CLS Bank design shouldsignificantly reduce the principal risk associated with FX settlement, which is the mostsignificant aspect of FX settlement risk. In the future, it is also possible that other options forreducing FX settlement risk will become available.

40. Banks with significant FX settlement exposures should give strong consideration tousing such risk-reducing arrangements, either by participating in them directly or by takingadvantage of third-party services. In evaluating whether to do this, banks should carefullyassess the costs associated with the exposures, including both expected losses and the cost ofeconomic capital associated with unexpected losses. While ultimately the decision to makeuse of risk-reducing arrangements should be based on the balance of all costs and benefits, itis particularly important that banks do not underestimate the benefits of risk reduction byassuming that sudden bank failures are impossible.

41. Banks that choose to participate in risk-reducing arrangements, such as CLS Bank,should recognise that such participation can have implications for a number of different partsof their organisations beyond the areas directly associated with payments processing.Accordingly, banks should develop an overall process for monitoring and assessing theseimplications (e.g. on trading and funding practices) and for ensuring that they are ready tocope with the changes that may result from their participation.

42. In addition, banks should understand that, while risk-reducing arrangements areintended to significantly reduce important settlement risks, they may not eliminate all suchrisks. Thus, banks using such arrangements should have a thorough understanding of themand of the remaining risks they face - for example, liquidity, legal and operational risks.Moreover, even if banks use alternative arrangements for deals with major counterparties,they are likely to continue to use the traditional gross settlement method for certaincounterparties and currencies. Therefore, banks should incorporate their use of alternativesettlement arrangements into measures of and limits on FX settlement exposures,understanding that use of such arrangements does not eliminate the need for all such tools.

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XII Internal audit

43. Banks should have in place adequate internal audit coverage of the FX settlementprocess to ensure that operating procedures are adequate to minimise settlement risk. Abank’s board of directors – either directly or through its audit committee - should ensure thatthe scope and frequency of the FX settlement internal audit programme is appropriate to therisks involved.

44. The board of directors or its audit committee should ensure that audit reports aredistributed to appropriate levels of management for information and so that timely correctiveaction can be taken. Management should detail, in writing, the action taken. The board ofdirectors or its audit committee should regularly review this and consider any outstandingissues. Where appropriate it should ensure that a follow-up audit is undertaken.

45. When audit findings identify areas for improvement in the FX settlement area, otherareas of the bank on which this may have an impact should be notified. This could includecredit risk management, reconciliations/accounting, systems development, and managementinformation systems. In automated settlement processing, the internal audit department shouldhave some level of specialisation in information technology auditing, especially if the bankmaintains its own computer facility.

XIII A bank's responsibilities to its counterparties

46. The emphasis in this guidance has been on the steps banks take to manage thesettlement risk that they themselves face. However, settlement risk is a two-way process – abank also needs to be aware that its own behaviour affects the settlement risk faced by itscounterparties. As discussed in paragraph 28 above, banks should react in a balanced andconsidered way to any perceived counterparty problems. Banks should also minimise thepossibility that, as part of their routine processing of FX settlements, they are the cause ofsettlement failures. For example, banks may want to consider whether, given the size andpattern of their transactions in the currencies concerned, they have enough liquidity on theirnostro accounts to avoid payments being delayed because of shortages of funds. Further, theuse of standardised settlement instructions may reduce the risk that payments areunintentionally mis-routed, particularly when there are changes to those instructions.Effective communication can also help to minimise the adverse impact of problems; it maytherefore be helpful for banks to ensure they have procedures for informing key counterpartieswhen significant operational problems arise. By taking such steps to avoid routine,operational fails, or to minimise their impact, banks will make it easier to identify those caseswhere there is a more serious underlying problem.

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XIV The role of supervisors9

47. Foreign exchange settlement risk is a dimension of counterparty risk at banks. Whilea bank’s board of directors and senior management remain responsible for the management ofFX settlement risk, supervisors have an interest in ensuring that banks measure, monitor andcontrol FX settlement risk appropriately. FX settlement losses can occur with any FX tradingcounterparty failure, but FX settlement exposures are particularly vulnerable to loss inconnection with systemic disturbances, such as when counterparty credit quality declinesprecipitously or credit and liquidity concerns intensify. FX settlement exposures are oftenconcentrated among the largest global banks and losses could therefore be substantial in theevent of the failure of a major global bank. Further, FX settlement losses are often seen bymarket participants as harbingers of more severe credit problems in the financial system,inducing caution among counterparties and adversely affecting bank liquidity and the flow ofbusiness activity. While such systemic disturbances are rare, the potential losses from FXsettlement risk can be very substantial, because of the exchange of principal and the largevolume of transactions.

48. Supervisors should require that banks engaging in FX trading have appropriatemethods of managing FX settlement exposures consistent with the guidelines in this report.Supervisors should expect all banks to measure FX settlement risk, set binding limits for allcounterparties, and monitor closely limit excesses and unusual settlement activity.Supervisors should expect a bank to use methods commensurate with the range and scope ofits activities and assess such methods as part of their ongoing supervisory activities.Supervisors should consult with the internal auditor to determine the adequacy of the riskassessment methodology used by the institution. In cases where supervisors determine that abank’s FX settlement risk management is not adequate or effective for that bank’s specificrisk profile, they should take appropriate action.

49. Supervisors can step up supervisory attention to this area by inquiring about andevaluating a bank’s improvements to its FX settlement process. Based on the work of theCommittee on Payment and Settlement Systems (CPSS), banks clearly can make substantialfurther improvements in their FX settlement practices to control and reduce FX settlementrisk. Thus, supervisors should place special emphasis on encouraging and monitoringreductions in the deadlines for irrevocable payments before payment date and in the timerequired to reconcile settlements. In addition, supervisors should focus on whether a bank hasfully and carefully evaluated the potential risk reductions that could be gained throughparticipation in initiatives to reduce FX settlement risk, including netting and other risk-reducing arrangements.

50. To ensure that FX settlement risk is properly managed, supervisors may find someform of on-site review helpful. The two CPSS studies on FX settlement risk mentioned earlier(see paragraph 3) provide very helpful background to supervisors. In conducting on-sitereviews, supervisors may also find the attached questions helpful.

9 In some cases supervisors may make use of the work of external auditors to ensure the described functions are carriedout.

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51. The most effective way to supervise FX settlement risk is to evaluate a bank’s riskmanagement process, while, over time, expecting substantial further improvements in riskmanagement techniques. Such improvements can be monitored using the benchmarksestablished in the two CPSS studies. If after some time FX settlement risk exposures remainat levels viewed by supervisors as higher than necessary given the sound practices in theseguidelines, supervisors could consider other supervisory tools they have available. Thosetools include imposing large exposure limits on FX settlement exposures and possiblyrequiring a bank to hold additional capital to support large FX settlement exposures.

52. The cross-border nature of the settlement process makes it imperative thatsupervisors share information about FX settlement risk problems or concerns at individualinstitutions and within marketplaces. Sharing information about how a FX settlement problemis being addressed can help prevent the spread of settlement distress to additional markets.

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Appendix 1

Key FX Settlement Risk Concepts

Definition of Foreign Exchange Settlement Exposure

An institution’s actual exposure – the amount at risk – when settling a foreign exchange tradeequals the full amount of the currency purchased and lasts from the time a paymentinstruction for the currency sold can no longer be cancelled unilaterally until the time thecurrency purchased is received with finality.

Although settling a trade involves numerous steps, from a settlement risk perspective a trade'sstatus - from the time it is executed until the time it is settled - can be classified according tofive broad categories:

Status DescriptionRevocable: The institution's payment order for the sold currency either has not been

issued or may be unilaterally cancelled without the consent of theinstitution's counterparty or any other intermediary. The institution faces nocurrent settlement exposure for this trade.

Irrevocable: The institution's payment order for the sold currency can no longer becancelled unilaterally either because it has been finally processed by therelevant payments system or because some other factor (e.g. internalprocedures, correspondent banking arrangements, local payments systemrules, laws, etc.) makes cancellation dependent upon the consent of thecounterparty or another intermediary; the final receipt of the boughtcurrency is not yet due. In this case, the bought amount is clearly at risk.

Uncertain: The institution's payment instruction for the sold currency can no longer becancelled unilaterally; receipt of the bought currency is due, but theinstitution does not yet know whether it has received these funds withfinality. In normal circumstances, the institution expects to have receivedthe funds on time. However, since it is possible that the bought currency

Revocable Irrevocable UncertainSettled

orFail

Trade Unilateralcancellationdeadline for

sold currency

Final receiptof bought

currency due

Identify final andfailed receipts ofbought currency

Foreign exchange settlement process:changing status of a trade

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was not received when due (e.g. owing to an error or to a technical orfinancial failure of the counterparty or some other intermediary), the boughtamount might, in fact, still be at risk.

Fail: The institution has established that it did not receive the bought currencyfrom its counterparty. In this case the bought amount is overdue and remainsclearly at risk.

Settled: The institution knows that it has received the bought currency with finality.From a settlement risk perspective the trade is considered settled and thebought amount is no longer at risk.

Additional Terms

Unilateral Payment Cancellation Deadline: The time beyond which an institution can nolonger stop a payment without the permission of a third party.

Minimum Measurement of Settlement Exposure: The sum of (1) exposures outstanding fortrades with status irrevocable and (2) any known failed receipts.

Maximum Measurement of Settlement Exposure: The sum of (1) exposures outstanding fortrades with status irrevocable, (2) exposures outstanding for trades with status uncertain and(3) any known failed receipts.

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Appendix 2

Possible Questions for On-site Reviews

These questions are intended only as a broad guide for supervisors and may need to bemodified depending on the bank concerned.

1. Overall management

Does responsibility for the management of FX settlement risk rest at a sufficiently senior levelof management? Does senior management exercise appropriate oversight of FX settlementexposures?

Is the management of FX settlement risk adequately integrated into overall risk managementof the bank?

Are there clear lines of responsibility within the bank? Is there adequate co-ordinationbetween different functions and locations of the bank? If conflicts arise (for example, over theuse of limits), do appropriate means to resolve them exist?

Are FX settlement risks fully understood by senior management and all those involved? Isadequate training in place to achieve this?

2. Measurement

Is the bank's measurement of risk based on a full understanding of the relevant factors,including the concepts of the unilateral cancellation time and the reconciliation time and howthese affect the maximum and minimum measures of the bank's exposure?

Has the bank taken appropriate steps to ensure reasonable certainty about its unilateralcancellation deadline?

Is the correspondent's cut-off time documented? Is this a contractual commitment rather thanon a best-efforts basis? Has the cut-off time been tested?

Has the bank given adequate consideration for the time needed to complete internalprocedures when it wants to cancel a payment instruction? Is its cancellation deadline basedon an ability to hold back individual payments at that time rather than to hold all paymentinstructions? Has allowance been made for cases where the correspondent's cut-off is out ofnormal hours? Have the internal procedures been tested?

Has the bank taken appropriate steps to ensure reasonable certainty about its reconciliationtime? Has adequate consideration been given to the time needed to carry out the reconciliationonce the information on payments credited to its nostro accounts has been received from itscorrespondents? Are procedures in place to cover situations when information from the

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correspondent bank is late? Are procedures in place to ensure that any failed transactions areincluded promptly in the bank's measure of its exposure?

Does the bank's measurement make appropriate allowance for variations in the cancellationand reconciliation times according to currency?

Where the bank uses an approximate measure of its exposure, does this measure avoid anysignificant underestimation?

3. Setting and using limits

Are the bank's settlement exposures subject to an adequate credit control process includingcredit evaluation and review and determination of the maximum exposure the bank is willingto take with a particular counterparty?

Are the limits mandatory? Is monitoring effective? Are excesses subject to approval by theappropriate credit management personnel in advance of the excess occurring or, if anunauthorised excess takes place, shortly afterwards?

Are these processes the same as those used to set and apply limits on other exposures ofsimilar duration and size to the same counterparties?

4. Identifying and managing fails

Does the bank have appropriate procedures for promptly identifying fails, informing the creditdepartment, initiating attempts to obtain the funds, identifying and reviewing the nature of theproblem and taking steps to avoid its recurrence?

5. Understanding the implications of techniques to manage exposures

Where the bank is using methods to reduce the size of its exposures (such as collateralarrangements, netting, derivative instruments or specialised settlement mechanisms) has thebank taken the necessary steps to ensure that the methods are legally robust and that theirimplications for FX settlement risk, including any residual risks, are fully understood andallowed for in the bank's risk management?

6. Contingency planning

Has the bank drawn up contingency plans for possible disruptions to the settlement of FXtransactions? Are the plans regularly tested?

7. Internal audit

Does the bank have adequate internal audit coverage of the FX settlement process?

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Appendix 3

Annotated Bibliography

Settlement risk can take many forms. This guidance is concerned with the risks associatedwith settling foreign exchange transactions, where the settlement risk is one of various formsof so-called "exchange-of-value" settlement risk. Exchange-of-value risk is a risk faced by thecounterparties to a transaction, and arises form the need for these counterparties to exchangeone item of value for another.

Exchange-of-value settlement risks can occur in the settlement of almost any kind oftransaction. In the case of FX settlement risk, the exchange is of one currency for another. Inmany other financial markets – such as securities markets, for example – a key form ofexchange-of-value settlement risk involves the exchange of financial instruments againstmoney. In each case, the particular characteristics of the market concerned and how its dealsare settled need to be understood in order that the settlement risk involved can be managedproperly.

The following publications provide more information relevant to the exchange-of-valuesettlement risks arising in various financial markets.

Foreign Exchange Settlement

Reducing Foreign Exchange Settlement Risk: A Progress Report, Committee on Paymentand Settlement Systems, BIS, July 1998.

• Provides an update on the private sector’s efforts to reduce foreign exchangesettlement risk.

• Reaffirms and strengthens the strategy of the G10 central banks toward foreignexchange settlement risk reduction.

Settlement Risk in Foreign Exchange Transactions, Committee on Payment and SettlementSystems, BIS, March 1996.

• Analyses existing arrangement for settling foreign exchange trades.

• Makes risk reducing recommendations.

• Identifies avenues for co-operation with the private sector and for advancing thecause of foreign exchange settlement risk reduction.

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Reducing Foreign Exchange Settlement Risk, The New York Foreign Exchange Committee,October 1994.

• Presents the results of a survey of foreign exchange market participants to determinecommon settlement procedures.

• Suggests ways of defining and measuring settlement risk.

• Offers a series of recommendations to reduce settlement exposures.

Central Bank Payment and Settlement Services with Respect to Cross-Border and Multi-Currency Transactions, Committee on Payment and Settlement Systems, BIS, September1993.

• Identifies and promotes a common understanding of the advantages anddisadvantages of different payment and settlement services that central banks mightoffer.

• Highlights how changes in certain features of home-currency payments systems caninfluence the risk and efficiency of international settlements.

• Emphasises the scope and need for private sector efforts to reduce risk and increaseefficiency in the settlement process.

Payment System Standards

Core Principles for Systemically Important Payment Systems (Parts 1 and 2), Committee onPayment and Settlement Systems, BIS, July 2000.

• Sets out ten core principles that systemically important payment systems shouldmeet.

• Sets out four responsibilities of the central bank in applying the core principles.

• Provides guidance on the implementation of the core principles and responsibilities.

Report of the Committee on Interbank Netting Schemes of the Central Banks of the Groupof Ten Countries (Lamfalussy Report), Committee on Payment and Settlement Systems, BIS,November 1990.

• Analyses the policy implications of cross-border and multi-currency nettingarrangements.

• Makes policy recommendations with respect to minimum standards for nettingsystems.

• Analyses the impact of netting on credit and liquidity risks and on the level ofsystemic risk.

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• Advances principles for co-operative central bank oversight of netting systems

Derivatives Settlement

ISDA Guidelines for Collateral Practitioners, International Swaps and DerivativesAssociation, Inc., 1998.

• Useful as a reference source for institutions managing collateral for derivativestransactions.

• Describes the basic legal issues underlying collateral arrangement for privatelynegotiated derivatives transactions.

• Describes and analyses the settlement risks associate with collateralised derivativestransactions.

OTC Derivatives: Settlement Procedures and Counterparty Risk Management, BIS,September 1998.

• Provides a comprehensive survey and analysis of the practices and procedures thatparticipants in over-the-counter derivatives markets use to manage their counterpartyrisks.

• Identifies weaknesses in practices that appear to exacerbate counterparty riskssignificantly or even possibly pose risks to the financial system systemically.

• Recommends changes in practices, including new services, that could mitigate therisks and weaknesses identified.

Clearing Arrangements for Exchange-Traded Derivatives, Committee on Payment andSettlement Systems, BIS, March 1997.

• Describes and analyses clearing arrangements for exchange traded derivatives in theG10 countries.

• Discusses the sources and types of risks to clearing houses and the risk managementsafeguards that clearing houses employ to manage those risks.

• Identifies several specific sources of potential vulnerability in clearing house riskmanagement systems.

• For each weakness identified, points out methods for strengthening clearingarrangements.

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Securities Settlement

Disclosure Framework for Securities Settlement Systems, Committee on Payment andSettlement Systems (BIS) and International Organisation of Securities Commissions,February 1997.

• Provides a standard format for reporting a securities settlement system’s operationand its allocation of risk.

• Intended as a tool for system operators and participants to use in discussing the risksassociated with securities settlement arrangements.

• Assists system operators and participants in gaining a clearer understanding of therights, obligations and exposures associated with securities settlement systems.

Cross-Border Securities Settlements, Committee on Payment and Settlement Systems, BIS,March 1995.

• Examines the channels that market participants use to settle cross-border securitiestransactions and discusses the utilisation of the various channels by different types oftraders.

• Identifies and analyses the risks associated with each of the major settlementchannels.

• Considers the implications of cross-border settlement arrangements for central bankpolicy objectives.

A Report on Cross-Border Risks, Payments Risk Committee, Securities Settlement Sub-Committee, March 1995.

• Pinpoints key settlement attributes as applied by specific settlement systems.

• Analyses six risks in cross-border activity.

• Recommends settlement practice improvements and suggests changes to universalrisk reduction techniques.

• Makes best practice recommendations.

Delivery Versus Payment in Securities Settlement Systems, Committee on Payment andSettlement Systems, BIS, September 1992.

• Analyses and discusses the types and sources of financial risk in the settlement ofsecurities transactions.

• Identifies and describes three possible approaches to achieving delivery versuspayment.

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• Identifies several risk management issues common to all three approaches andcommon safeguards that may be employed to reduce risk.

• Considers whether the standards for the design and operation of cross-border andmulti-currency netting and settlement schemes that were developed in theLamfalussy Report also provide a useful framework for evaluating the implicationsof the design and operation of securities settlement systems for central bank policyoperations.

Clearance and Settlement Systems in the World’s Securities Markets, Group of Thirty,March 1989.

• Makes nine recommendations for improving the working of world securities marketsthrough the adoption of sound practices and standards.

• Proposals are designed to achieve the following objectives:

• Match trades by the day after trade date (T+1).

• Settle trades on a continuous basis, and by T+3.

• Exchange value for value on a consistent basis.

• Improve efficiency by using depositories, netting mechanisms, and standardnumbering systems whenever appropriate.

Relevant Web Sites

Bank for International Settlements: http//www.bis.org

A source of many publications relating to all aspects of settlement risk.

International Finance & Commodities Institute: http//risk.ifci.ch

Attempts to impose a logical order to the wide universe of on-line regulatory documentsconcerning risk. Definitions and discussion.

International Swaps & Derivatives Association, Inc.: http//www.isda.org

Significant source of information about the settlement of derivatives transactions.

Payments Risk Committee: http//www.ny.frb.org/prc

Private sector group in New York that identifies and analyses issues of mutual interest relatedto risk in payments and settlement systems.